Aflac: Don't Fear Japanese Exposure

| About: Aflac Incorporated (AFL)

Aflac (NYSE:AFL) is an insurance company known in the U.S. for its duck mascot and memorable commercials. What many do not know, however, is that Aflac is the leading life and supplemental insurer in Japan and the leading provider of supplemental insurance in the United States. This exposure to Japan is becoming increasingly important as uncertainty from Japanese markets is causing the stock to sit below its fair value. A thorough examination of Aflac reveals a well managed insurance company that has surprisingly little to fear from volatility in Japan.

Company Overview

Aflac offers a wide variety of products, but their primary niche is supplemental insurance. Supplemental coverage, as the name implies, supplements existing health insurance by providing additional benefits for specific events. Types of supplemental policies include cancer insurance, hospitalization insurance, and accident insurance. Supplemental policies are subject to far fewer claims than general policies, so they are much safer from the point of view of the insurer. In fact, in the 1990's a study revealed that supplemental insurance plans only paid out 35% of the premiums they took in. This is far lower than traditional insurance policies. Supplemental insurance policies are very profitable for the companies that issue them.

The Fundamentals

Aflac has a trailing P/E of 8.85. As seen in the P/E graph below, this is noticeably lower than the earnings multiples that Aflac has traded at in the past. In actuality, the stock is even cheaper than it seems, as the weakening of the yen has caused earnings to be understated. Aflac's earnings are expected to grow by 8.5% over the next five years. Currently Aflac yields 2.23% with a very low payout ratio of 19%. This ensures that the dividend is safe and that it will continue to be raised. As seen in the graph of dividend payments, Aflac has consistently raised its dividend for decades. As a result of this, Aflac is on the radar of many dividend growth investors.

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Aflac is in a sound financial position. In its 2nd Quarter Report, Aflac estimated its RBC ratio to be above 700%. RBC stands for Risk Based Capital and it represents the minimum amount of capital an insurer needs to support its operations and write coverage. Aflac currently has 7x the amount of capital it needs, thus ensuring that the company is able to pay its policy holders and grow its business. This is a sizable increase from its year end ratio of 630%. Aflac's SMR stands at 585% as of June 30, 2013. SMR, or Solvency Margin Ratio, is the amount by which an insurance company's capital exceeds its projected liabilities. While Aflac's SMR has declined during 2013, its Q2 SMR is still at the high end of its targeted range. Aflac's financial ratios show it is in good financial shape.

Impact of the ACA and Further Healthcare Reform

It would be remiss to write an article about a health insurance company, even one that only does a quarter of its business in the U.S., without discussing the impact of the Affordable Care Act. The Affordable Care Act, also known as Obamacare, will require all Americans to purchase a minimum amount of health insurance. There are a wide range of opinions as to how Obamacare will affect the insurance industry. However, one thing that is certain is that this act does not address supplemental coverage. In a letter to shareholders, CEO Dan Amos stated that the Affordable Care Act will not directly impact Aflac's business.

Aflac would benefit tremendously if the United States were to adopt a universal healthcare system. If such a change were to occur it will likely be far in the future. It would also dramatically alter the health insurance landscape and help Aflac enormously. When primary health insurance is handled by the government, typically citizens are provided basic coverage and they need to purchase supplemental policies for additional protection. Aflac's supplemental allows individuals to tailor their healthcare in order to obtain their desired level of coverage. Japan serves as a model for success given that they have a universal health care system in place and Aflac has thrived. Aflac has a large advantage over competitors in the supplemental market as they have decades of experience operating primarily in this niche. Other companies would be forced to play catch up and enter the supplemental market where they have far less experience than Aflac. While the United States is still far from implementing true universal health care, Aflac stands to benefit should steps be taken in that direction.

Effect of Rising Interest Rates and Currency Fluctuations

Much has been made about Aflac's exposure to Japanese debt. Many are worried that interest rates will rise and Aflac's bond portfolio will be hurt. These arguments fail to take into account the fact that most of the bonds owned by Aflac can and will be held to maturity. This minimizes any effect rising interest rates will have on the value of their bond portfolio because when holding to maturity, only a default can cause a loss. The very low yields of Japanese bonds imply the odds of a default are next to nonexistent. Furthermore, Aflac has announced it has opened positions hedging its exposure to rising interest rates on Japanese government debt. This will enable Aflac to limit losses should they need to sell off portions of their portfolio in times of higher interest rates. Short of the Japanese government defaulting on its debts, Aflac's bond portfolio appears safe.

Also, many have speculated on the effect the weakening of the yen will have on Aflac's profitability. However, Aflac almost never converts yen to dollars, or vice versa, so the exchange rate is completely irrelevant to its business. The exchange rate is only used on the financial statements, when they are required to report everything in U.S. dollars regardless of whether the item being reported is denominated in dollars or yen. This creates the illusion of greater profits when the yen is strong and lower profits when the yen is weak.

As a result of this, when reviewing Aflac's financial reports, it's important to look at the section titled "Effect of Foreign Currency on Operating Results". This section paints a clearer picture of the change in income generated by the companies Japanese operations by eliminating differences in the conversion rates from year to year. When looking at the Q2 2013 results, Aflac appears to have grown operating earnings by .5% compared to Q2 2012. After adjusting for currency changes, it is revealed that operating earnings actually grew by 14.1%. Since Aflac does not regularly exchange currency, exchange rates have little impact on its actual profitability.


Aflac's current share price is the result of uncertainty in Japanese markets and in no way reflects the company's true value. As Japan is in a period of economic uncertainty, many fear that yields will rise and the yen will lose value. While these events may occur, they will have little to no impact on Aflac's profitability. Aflac dominates the supplemental and life insurance markets in Japan and the supplemental insurance market United States, with its business in the latter being greater than its four closest competitors. Aflac is a company with a durable moat and a rising dividend whose price is being held down by unfounded concerns.

Disclosure: I am long AFL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.